Tag: USA

The U.S. economy is in desperate need of a strong dose of fiscal penicillin

From The Conversation.

Despite six years of “recovery” from the Great Recession, America’s middle class still struggles financially amid sluggish economic growth and middling job creation.

The Federal Reserve’s near-zero interest rates have helped stabilize the economy after it nearly went into freefall in 2008 and 2009, but that policy is coming to an end, with at least one quarter-point hike expected this year and more in 2017 and 2018.

So what will support the economy once the Fed’s largesse begins to disappear?

I’ve been exploring the key economic data – from productivity and housing to wage growth and consumer spending – to better understand where we’re headed and what is needed to get out of this no-to-low growth environment, a pernicious state some economists call secular stagnation. The data show clearly why serious attention is needed to foster faster growth, a more competitive economy and more opportunities for American families.

And only one institution, I would argue, is able to do something about it: Congress.

Stagnant growth and productivity

For most of the recovery, economic growth has been lackluster.

Gross domestic product has expanded at an average annual inflation-adjusted rate of just 2 percent since the recession ended in the second quarter of 2009, far below the rate of 3.4 percent from December 1948, when the first recession after World War II started, to December 2007, when the most recent recession began. And in just the past three quarters through June, the economy has barely budged, growing at an anemic 1 percent or so.

Productivity growth, measured as the increase in inflation-adjusted output per hour, is key to propelling strong economic growth because it means that workers are getting better at doing more in the same amount of time. Yet productivity rose only a total of 6.6 percent from the second quarter of 2009 to the second quarter of 2016. That amounts to an average rate of 0.9 percent a year, a fraction of the 2.3 percent we experienced from 1948 to 2007.

Housing hasn’t recovered

When considering what’s keeping the recovery from taking off, housing deserves particular attention since it generally boosts economic growth after a recession. Not this time.

Sales of new single-family homes have been on the rise in recent years, but they’re still well below the historical average before the Great Recession, pushing homeownership down to a 50-year low. Sales averaged about 400,000 a year from 2011 to 2015, compared with 698,000 before the recession – from 1963 through 2007.

Although the pace has picked up in recent months – reaching an annual rate of 609,000 in August – it’s still not enough to stop the slide in the homeownership rate, which was 62.9 percent in the second quarter, down from 67.8 percent at the end of 2007.

And spending on housing fell 7.7 percent in the second quarter of 2016, compared with the first three months of the year.

One of the reasons housing has been slow to recover – the market’s collapse was the primary cause of the Great Recession – is that employment growth has remained mostly moderate. Many are still looking for good jobs despite the sharp drop in headline unemployment to an eight-year low of 4.9 percent.

The average annualized employment growth rate from June 2009 to August 2016 was just 1.4 percent, well below the long-run average of 1.9 percent from December 1948 to December 2007.

While there were 13.6 million more jobs in August than in June 2009 – meaning that the economy regained all those lost during and immediately after the recession – these gains and the comparatively low unemployment rate obscure that many people still cannot find the jobs they want. The jobless rate means about 7.8 million individuals were unemployed in August, yet another 7.8 million were either employed part time for economic reasons (they would have preferred a full-time job) or out of work and wanted a job but weren’t counted in the official rate because they hand’t looked in the preceding four weeks.

And communities of color still have higher unemployment rates than whites. The African-American unemployment rate stood at 8.1 percent, while for Hispanics it was 5.6 percent, compared with 4.4 percent for whites.

Wage growth, income inequality and debt

These lackluster job gains have meant there’s less pressure on employers to raise wages. And sluggish wage growth has meant less consumer spending – which typically makes up more than two-thirds of GDP.

Wages, in fact, have barely kept pace with price increases. Inflation-adjusted hourly earnings of production and non-supervisory workers – about 80 percent of the labor force – have increased only about 4.5 percent since June 2009. This amounts to an annualized growth rate of merely 0.6 percent above the rate of inflation over the past seven years.

Low wage growth has kept income inequality at very high levels. A recent report offered some good news: Real median household income grew at 5.2 percent, from US$53,718 in 2014 to $56,516 in 2015 – the fastest annual growth on record dating back to 1968. But inflation-adjusted median income was still higher in 2007 than in 2015.

Middle-class Americans are only slowly gaining ground as wealthier ones had seen bigger gains, leaving income inequality persistently high. In 2015, the top 5 percent of earners captured 22.1 percent of total income, compared with 11.3 percent for the bottom 40 percent. In 1967, those at the top took home 17.2 percent, versus 14.8 percent for the bottom 40 percent.

This lack of wage growth also makes it difficult for households to dig out from under a mountain of debt, which further contributes to limited spending on housing and other items. Household debt equaled 105.2 percent of after-tax income in the second quarter of 2016. While that’s down from a peak of 135 percent in the fourth quarter of 2007, the current level is still much higher than any level of debt observed in the 50 years before 2002.

Moreover, some especially costly forms of credit have grown. Installment debts – mainly student and car loans – have grown from 14.6 percent of after-tax income in June 2009 to 19.2 percent this past June – the highest share since records began in 1968.

Unsurprisingly, consumer spending growth has been middling as a result, increasing an average of just 2.3 percent a year since the end of the Great Recession, far below the long-term average of 3.5 percent from 1948 through 2007.

Companies on the sidelines

With their consumers still mired in debt with little gain in their pocketbooks, businesses have very few reasons to invest.

Net investment – what companies spend on new capital assets rather than on replacing obsolete items – has averaged 1.9 percent of GDP since the recession started at the end of 2007. This is the lowest since World War II.

To be clear, companies have the money. Corporate profits recovered quickly toward the end of the Great Recession and have stayed high since.

So where is all that money going? Cash reserves and shareholders.

Nonfinancial corporations hold an average of 5.2 percent of all of their assets in cash – a high rate by historical standards. At the same time, they spent on average 99 percent of their after-tax profits on dividend payouts and share repurchases to keep their shareholders happy since the start of the Great Recession.

Breathing room

With consumers not spending money because they can’t and businesses not spending money because they don’t want to, the onus falls on Congress to bolster the economy and the labor market.

Yet federal, state and local government spending has been falling. Their total spending on goods and services as a share of GDP was 17.7 percent in the second quarter of 2016, the smallest share since 1998.

Congress, though, now has room to maneuver. The nonpartisan Congressional Budget Office estimated in August that the federal government will have a deficit of 3.2 percent of GDP for fiscal year 2016. This is much smaller than in recent years, including 2009’s deficit of 9.8 percent of GDP – the widest since World War II.

The shrinking deficit, as well as the government’s near-record-low borrowing costs, could provide enough breathing room to focus on targeted, efficient policies that promote long-term economic growth and shared prosperity, for instance, through investments in infrastructure.

The economy and American families need Congress to use this breathing room to create real economic security.

Author: Christian Weller, Professor of Public Policy and Public Affairs, University of Massachusetts Boston

Another Revenue Challenge

According to Moody’s the new Focus on US Banks’ Sales Practices Is Another Revenue Challenge.

Last Tuesday, Thomas Curry, head of the US Office of the Comptroller of the Currency (OCC), indicated during testimony before the US Senate Banking, Housing and Urban Affairs Committee that his agency will conduct a horizontal review of sales practices at the nation’s largest banks. Later, Consumer Financial Protection Bureau (CFPB) Director Richard Cordray added that his agency would be “doing a joint action” with the OCC.

We believe regulators will conduct a particularly thorough review of the industry’s sales practices in response to the media and political spotlights on Wells Fargo & Company’s (A2 stable) recently disclosed wrongdoings, the unauthorized opening of up to 2.1 million deposit or credit card accounts. For the banks, the additional regulatory focus is credit negative because it will increase scrutiny on deposit fees, which are a meaningful contributor to their revenue.

Deficient sales practices have only been highlighted at Wells Fargo and nowhere else. Nonetheless, in underscoring the need for a broader review, Mr. Curry highlighted the importance of incremental product sales and fees, noting that protracted low interest rates put the industry, not just Wells Fargo, “under enormous margin pressure.”

As shown in Exhibit 1, Federal Deposit Insurance Corporation (FDIC) data show that service charges on deposit accounts are significant for the industry, totaling nearly $34 billion in 2015, or 14% of total noninterest revenue. Large as this number is, it has fallen in absolute terms and as a percentage of non-interest income since the 2008-09 financial crisis, primarily because of heightened regulation. The additional exams announced last week will only reinforce existing scrutiny over specific revenue sources, such as overdraft fees.

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The misconduct at Wells Fargo has put all large banks in the regulators’  crosshairs. Exhibit 2 shows that for most large banks, deposit service charges are a meaningful contributor to overall revenue; that is, the combination of net-interest income and non-interest income. Specifically, for the first six months of 2016, 16 large banks reported a median contribution to total revenue of 6.7% from service charges on domestic deposit accounts, with one bank in the group, Regions Financial Corporation (Baa3 review for upgrade), earning 12% of its total revenue from this source.

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Although some senators at last week’s hearing highlighted their worry that inappropriate sales practices could be widespread, that determination has not yet been made. Regardless, we believe the revelations at Wells Fargo will cause banks to tread cautiously before rolling out more aggressive sales initiatives in the current environment. That alone will constrain their revenue growth

US Household Net Worth Rises

The latest (Q2 16) US Financial Accounts have been released, containing data on the flow of funds and levels of financial assets and liabilities. The data will increase the likelihood of a fed rate rise, offsetting the more negative news released yesterday.

The net worth of households and nonprofits rose to $89.1 trillion during the second quarter of 2016. The value of directly and indirectly held corporate equities increased $452 billion and the value of real estate rose $474 billion. The figure plots the contributions to the change in net worth of households and nonprofit organizations. The black line plots the total change in net worth, while the bars represent the changes in the main components of net worth: market value of directly and indirectly held corporate equity (dark blue), market value of real estate holdings (green), and other assets net of liabilities (light blue). Other assets include consumer durable goods, nonprofit organizations’ fixed assets, and financial assets other than corporate equity.

Change in Net Worth: Households & Nonprofits. See accessible links below for data and a description of the figure.

Household debt increased at an annual rate of 4.4 percent in the second quarter of 2016. Consumer credit grew 6.4 percent, while mortgage debt (excluding charge-offs) grew 2.5 percent at an annual rate.

Domestic nonfinancial debt outstanding was $46.3 trillion at the end of the second quarter of 2016, of which household debt was $14.5 trillion, nonfinancial business debt was $13.2 trillion, and total government debt was $18.6 trillion. The figure plots the 4-quarter moving average percent growth rate of debt outstanding for domestic nonfinancial sectors at a quarterly frequency. The growth rate of debt is calculated as the seasonally adjusted flow divided by the seasonally adjusted level in the previous period, multiplied by 100. In the Financial Accounts, debt equals the sum of debt securities and loans.

Debt Growth of Domestic Nonfinancial Sectors. See accessible links below for data and a description of the figure.

Domestic nonfinancial debt growth was 4.4 percent at a seasonally adjusted annual rate in the second quarter of 2016, down from an annual rate of 5.4 percent in the previous quarter.

Nonfinancial business debt rose at an annual rate of 4.1 percent in the second quarter, down from an annual rate of 9.4 percent in the previous quarter.

State and local government debt rose at an annual rate of 2.2 percent in the second quarter of 2016, up from an annual growth rate of 0.8 percent in the previous quarter.

Federal government debt increased 5.0 percent at a seasonally adjusted annual rate in the second quarter of 2016.

Rate Hikes Will Be the Least of Market Worries – Moody’s

Moody’s says the Fed does not set interest rates in a vacuum. Indeed, the federal funds rate is shaped by a host of drivers that are hardly limited to labor market conditions.

Despite warnings from high-ranking Fed officials that ultra-low interest rates are not forever, recent soundings of business activity, as well as the nearness of November 8’s Presidential election, weigh against a hiking of the federal funds rate prior to the FOMC’s December 14 meeting. Moreover, recent data question whether 2016 will be home to even a single rate hike.

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In a September 12 speech, Fed governor Lael Brainard presented a convincing case favoring an extended stay by exceptionally low benchmark interest rates. On several occasions, Governor Brainard challenged the wisdom of a preemptive rate hike that intends to thwart inflation before it takes hold. Given “the absence of accelerating inflationary pressures” and the limited scope for lowering of fed funds in the event recession risks rise, Brainard argues for the continuation of a highly accommodative monetary policy. Basically, the macroeconomic costs of mistakenly hiking rates too early are viewed as well exceeding the potential inflationary costs of waiting too long to confront inflation. The damage done by a premature rate hike may be harder to repair than the damage resulting from above-target price inflation.

However, there is an alternative view that views ultra-low interest rates as doing more harm than good because of how cheap money (i) boosts savings in order to compensate for negligible interest income and (ii) forces investors to purchase riskier assets offering higher, though volatile, returns.

Futures now sense 2016 will end without a rate hike

As measured by the CME Group’s FedWatch tool, fed funds futures assign an implied probability of only 12% to a hiking of fed funds at the September 21 meeting of the FOMC. Thereafter, the implied likelihood barely rises to 20% for the November 2 meeting and climbs no higher than 47% for the FOMC’s deliberations of December 14. For now, the futures market does not expect a single rate hike for 2016.

The latest declines by the implied probabilities of rate hikes at the FOMC’s remaining three meetings for 2016 stemmed from lower than expected August readings for retail sales and industrial production. Despite the latest indications of subpar business sales, US equities rallied. Moreover, an accompanying drop by the VIX index hinted a narrowing of the high-yield spread that recently widened from September 8’s 18-month low of 508 bp to September 14’s 538 bp. Nevertheless, at some point, the corporate earnings outlook will overrule the now predominant influence of Fed policy. Unless business sales soon accelerate sufficiently, market participants will begin to fret over the adequacy of earnings for 2016’s final quarter and all of 2017.

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US Production Index Lower Than Expected

Latest figures from the US Federal Reserve shows that industrial production decreased 0.4 percent in August after rising 0.6 percent in July. The market reacted to this data, taking it as an indicator that a rate rise was less likely in the short term.

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Manufacturing output declined 0.4 percent in August, reversing its increase in July; the level of the index in August is little changed from its level in March. Following two consecutive monthly increases, the index for utilities fell back 1.4 percent in August. Even so, the index was 1.7 percent above its year-earlier level, as hot temperatures this summer boosted the usage of air conditioning.

The output of mining moved up 1.0 percent in August, its fourth consecutive monthly increase following an extended downturn; the index, however, was still about 9 percent below its year-ago level. At 104.4 percent of its 2012 average, total industrial production in August was 1.1 percent lower than its year-earlier level. Capacity utilization for the industrial sector decreased 0.4 percentage point in August to 75.5 percent, a rate that is 4.5 percentage points below its long-run (1972–2015) average.

Market Groups

The indexes for all major market groups declined in August. The output of consumer goods decreased 0.2 percent as a result of a large drop in consumer energy products and a small decline in consumer non-energy nondurables. The output of consumer durables was unchanged; a gain in automotive products was offset by declines in all of its other components. Business equipment posted a decrease of 0.4 percent, as gains of 1 percent or more for transit equipment and for information processing equipment were outweighed by a cutback of nearly 2 percent for industrial and other equipment. The output of defense and space equipment declined 0.6 percent. The indexes for construction supplies and business supplies moved down 0.6 percent and 0.8 percent, respectively. The production of materials decreased 0.5 percent: Both durable and energy materials posted declines, while the output of nondurable materials was unchanged. The reduction in the index for durable materials reflected similarly sized losses across all its major categories.

Industry Groups

Manufacturing output declined 0.4 percent in August; the index was also 0.4 percent below its level of a year earlier. In August, the production of nondurables moved down 0.2 percent, and the indexes for durables and for other manufacturing (publishing and logging) fell 0.6 percent and 0.7 percent, respectively. Many durable goods industries posted declines of nearly 1 percent or more, with the largest drop, 1.9 percent, recorded by machinery. Within nondurables, gains for food, beverage, and tobacco products and for paper were more than offset by declines elsewhere; the largest decrease, 2.1 percent, was recorded by textile and product mills.

The index for mining moved up 1.0 percent in August, with a decline in coal mining outweighed by increases in the indexes for oil and gas extraction, for oil well drilling and servicing, and for metal ore and nonmetallic mineral mining.

Capacity utilization for manufacturing decreased 0.4 percentage point in August to 74.8 percent, a rate that is 3.7 percentage points below its long-run average. The operating rate for nondurables moved down 0.2 percentage point; the rates for durables and for other manufacturing (publishing and logging) each declined 0.5 percentage point. The operating rate for mining moved up 1.0 percentage point to 76.2 percent, while the rate for utilities decreased 1.3 percentage points to 80.4 percent.

Wells Fargo Bank fined $100 million for widespread unlawful sales practices

According to the US Consumer Finance Protection Bureau (CEPB), hundreds of thousands of accounts secretly created by Wells Fargo Bank employees has led to an historic $100 million fine.

Complainy

Today we fined Wells Fargo Bank $100 million for widespread unlawful sales practices. The Bank’s employees secretly opened accounts and shifted funds from consumers’ existing accounts into these new accounts without their knowledge or permission to do so, often racking up fees or other charges.

The Bank had compensation programs for its employees that encouraged them to sign up existing clients for deposit accounts, credit cards, debit cards, and online banking. According to today’s enforcement action, thousands of Wells Fargo employees illegally enrolled consumers in these products and services without their knowledge or consent in order to obtain financial compensation for meeting sales targets.

Bank employees temporarily funded newly-opened accounts by transferring funds from consumers’ existing accounts in order to obtain financial compensation for meeting sales targets. These illegal sales practices date back at least five years and include using consumer names and personal information to create hundreds of thousands of unauthorized deposit and credit card accounts.

The law prohibits these types of unfair and abusive practices.

Violations covered in today’s CFPB order include:

  • Opening deposit accounts and transferring funds without authorization, sometimes resulting in insufficient funds fees.
  • Applying for credit-card accounts without consumers’ knowledge or consent, leading to annual fees, as well as associated finance or interest charges and other late fees for some consumers.
  • Issuing and activating debit cards, going so far as to create PINs, without consent.
  • Creating phony email addresses to enroll consumers in online-banking services.

 Enforcement Action

Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, we have the authority to take action against institutions that violate consumer financial laws. Today’s order goes back to Jan. 1, 2011. Among the things the CFPB’s order requires of Wells Fargo:

  • Pay full refunds to consumers.
  • Ensure proper sales practices.
  • Pay a $100 million fine.

Today’s penalty is the largest we have imposed. Other offices or agencies are also taking actions requiring Wells Fargo to pay an additional $85 million in penalties.

In a discussion on the Knoweldge@Wharton site, they highlight this may not be a one off. The “cross sell” business model underpinning banking is to blame.

More Banks May Be Involved: “It’s not just Wells Fargo,” says Cook. “Fees are a critical part of the profit model for banks in the U.S.” Conti-Brown agrees, and says the practice of cross-selling brings in the fee income that banks badly want. “Cross-selling is one of the reasons Wells Fargo is said to be so successful,” he says of the bank, which along with its parent of the same name, controls some $1.9 trillion in assets. “The [bank’s] incentive structure is flawed,” he says, explaining that deviant practices could occur if top management ties employee rewards to signing up existing customers to more products and services.

Does VIX Suggest a Lower Default Rate?

According to Moody’s, the US equity market can help divine the path to be taken by the high-yield default rate. However, changes in the market value of US common stock are not the equity market’s primary channel of
prediction. Rather, the VIX index, which estimates the implied volatility of the S&P 500 stock price index over the next 30-day span, offers the more reliable guide to where defaults may be headed.

The VIX index estimates the equity market’s expectation of stock price volatility. As the market becomes more worried over a possible deep sell-off of equities, the VIX index rises. By itself, such fear may reduce financial market liquidity, including the willingness to lend to high-yield credits.

The uncertainty that drives the VIX index higher often stems from signs of an extended stay by weaker corporate earnings. Significantly lower earnings, if not outright losses, will increase defaults among more marginal business credits. Downwardly revised earnings prospects, more frequent defaults, and heightened equity market volatility can only boost risk aversion and, thereby, diminish systemic liquidity.

These adverse developments will add to the difficulty of raising cash via asset sales and will lessen the willingness of healthy companies to purchase financially stressed businesses.

Since year-end 2003, the high-yield default rate has generated a very strong correlation of 0.91 with the moving yearlong average of the VIX index from three months earlier. As opposed to an average measured over a shorter span, the VIX index’s moving yearlong average helps to explain the default rate partly because the default rate is measured over a yearlong span.

vix-sept-2016

As derived from a regression model, the VIX index’s latest moving yearlong average of 17.2 predicts a midpoint of 2.9% for the high-yield default rate of three months hence. Though few, if any, expect the default rate to sink from its recent 5.5% to 2.9% three months from now, the VIX index’s recent trend weighs against an extended climb by the default rate that might distend the already above-trend yield spreads of medium- and speculative-grade corporate bonds.

Nevertheless, the VIX index’s predictive power might now be criticized on the grounds that it has been skewed lower by expectations of a prolonged stay by a very accommodative monetary policy. The equity market may have concluded that the FOMC will not dare risk a deep slide by share prices that could slash confidence and diminish liquidity by enough to bring a quick end to the current business cycle upturn. A recent ultra-low VIX index of 12.1 points suggests that the equity market is supremely confident of monetary policy’s willingness and ability to quickly remedy a potentially disruptive slowdown by business activity.

U.S. economy adds fewer jobs than expected; Fed rate move in doubt

As reported in the Globe and Mail, U.S. employment growth slowed more than expected in August after two straight months of robust gains and wage gains moderated, which could effectively rule out an interest rate increase from the Federal Reserve this month.

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Nonfarm payrolls rose by 151,000 jobs last month after an upwardly revised 275,000 increase in July, with hiring in manufacturing and construction sectors declining, the Labor Department said on Friday. The unemployment rate was unchanged at 4.9 per cent as more people entered the labour market.

“This mixed jobs report puts the Fed in a tricky situation. It’s not all around strong enough to assure a September interest rate hike. But it’s solid enough to engender a heated policy discussion,” said Mohamed el-Erian, chief economic adviser at Allianz, in Newport Beach, California.

Economists polled by Reuters had forecast payrolls rising 180,000 last month and the unemployment rate slipping one-tenth of a percentage point to 4.8 per cent.

Last month’s jobs gains, however, could still be sufficient to push the Fed to raise interest rates in December. The rise in payrolls reinforces views that the economy has regained speed after almost stalling in the first half of the year.

The report comes more than two weeks before the U.S. central bank’s Sept. 20-21 policy meeting. Rate hike probabilities for both the September and December meetings rose after remarks last Friday by Fed Chair Janet Yellen that the case for raising rates had strengthened in recent months.

Following the report, financial markets were pricing in a 27 per cent chance of a rate hike this month and a 57.7 per cent probability in December, according to the CME Fedwatch tool.

The Fed lifted its benchmark overnight interest rate at the end of last year for the first time in nearly a decade, but has held it steady since amid concerns over low inflation.

The dollar fell against a basket of currencies after the report, while prices for U.S. government bonds rose. U.S. stock futures rose.

“As far as the Fed is concerned, I don’t think it’s a number that is a major setback for what they ultimately want to achieve, which is a slow and gradual pace for a rate normalization,” said Jason Celente, senior fixed income portfolio manager at Insight Investment in New York.

Default Risk On The Up, Moody’s

Moody’s says that markets are now relatively sanguine about default risk, effectively concurring with the baseline forecast of Moody’s Default Study. However, compared to baseline default forecast, more can go wrong than right.

After rising from September 2014’s current cycle low of 1.6% to July 2016’s 5.5%, the baseline forecast sees the US high-yield default rate peaking in early 2017 at roughly 6.5%. Thereafter, the baseline prediction has the default rate receding to 4.9% by July 2017.

The baseline forecast is bordered by considerable downside risk. In addition to the baseline view, Moody’s Investors Service supplies optimistic and pessimistic projections for the default rate. The optimistic scenario projects a 5.3% average default rate for January-July 2017 that hardly differs from the 5.6% projected average of the baseline view. In stark contrast, January-July 2017’s 13.7% average expected default rate of the pessimistic scenario towers over the baseline forecast.

On balance, the default forecast suggests that the best days of the current credit cycle have passed. Even if the optimistic backdrop holds true, the default rate is likely to remain above-trend given the presence of an economic recovery. That is: The optimistic scenario predicts a range of default rates that exceeds both the average and median default rates of economic recoveries. Even if the optimistic view is correct, the default rate may still exceed its average, or trend, of an economic upturn.

Since the 1981-1982 recession, whenever the US lagging 12-month high-yield default rate either mostly or entirely overlapped an economic recovery, the default rate revealed a median of 3.4% and an average of 4.1%. By contrast, the default rate generated a median of 10.7% and an average of 9.6% whenever the yearlong observation period either mostly or entirely overlapped a recession.

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Recessions joined three of the four prior climbs by the default rate to 6.5%. Following each of the three previous episodes showing a climb by the default rate up to 6.5%, the default rate continued its ascent. After first reaching 6.5% in February 2009, April 2000, and February 1990, the default rate eventually crested at 14.7% in November 2009, 11.1% in January 2002, and 12.4% in June 1991. Coincidentally, a recession overlapped each of the default rate’s last three peaks. In addition, the equity market suffered deep setbacks at some point during the 12 months prior to the peaking of the default rate.

Only once has an ascent by the default rate to 6.5% not been followed by a recession within 12 months. The lone exception occurred during the mid-1980s, or when the default rate first approached 6.5% in July 1986. Thereafter, the default rate formed a localized peak at the 7.0% of April 1987.

The 1986-1987 climb by the default rate was linked to a profound deceleration by the annual increase of corporate gross-value-added — a proxy for corporate net revenues — from 1984’s patently unsustainable 12.1% surge to the 3.8% of the year-ended March 1987. Partly because of a less pronounced slowing of employment costs to the 6.4% annual increase of the year-ended March 1987, operating profits went from soaring higher by 20.8% annually in 1984 to contracting by -9.1% annually for the 12-months-ended March 1987.

However, during the ensuing two years, corporate credit quality benefited from an 8.2% average annual advance by corporate gross-value-added that stoked an accompanying 14.9% average annual increase by operating profits.

Thus, the market’s current expectation of a limited rise and subsequent fall by the high-yield default rate implicitly assumes a major rejuvenation of net revenues. As derived from the US National Income Product Accounts (NIPA), corporate gross-value-added slowed from the 5.4% annual increase of the year-ended June 2015 to the 2.1% of the year-ended June 2016. Partly because the deceleration by net revenues was more pronounced than the comparably measured ebbing of employment cost growth from 5.4% to 4.7%, the annual percent change of operating profits switched direction from the 4.7% increase of the year-ended June 2015 to the -6.8% contraction of the year-ended June 2016.

The Timing of Labeling a Bank “Too Big to Fail” Matters

From the St. Louis Fed On The Economy Blog.

When banks that are considered “too big to fail” (TBTF) are on the verge of failure and are subsequently saved by the government, many argue that the government is bailing out stock and bond holders at taxpayer expense. However, exactly who gets bailed out may be unclear. An Economic Synopses essay argues that it depends on when the institution is labeled TBTF.

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Director of Research Christopher Waller noted that current stock and bond holders of failing banks get bailed out if the institutions are unexpectedly declared TBTF at the moment they are about to default. This is because markets haven’t had time to incorporate the TBTF news into asset prices.

However, it’s when banks are considered TBTF prior to default that the issue of who gets bailed out becomes murkier. Waller quoted authors of a 2004 book Ron Feldman and Gary Stern about the problem: “‘The roots of the TBTF problem lie in creditors’ expectations … and the source of the problem is a lack of credibility’ that the government will let them fail.”1 Waller wrote: “It is exactly this timing that makes it difficult to determine who benefits from TBTF.”

A TBTF Announcement and Reaction

Waller gave an example of a bank (which he simply called bank A) that had been declared TBTF by the government. In response, the prices of the bank’s stocks and bonds would rise to reflect this new information. Subsequent offerings would also have higher prices, again due to the TBTF designation (and corresponding lack of default risk).

Investors who buy this bank’s stocks or bonds after the announcement, however, wouldn’t necessarily see a benefit. Waller noted that the TBTF status should be fully incorporated into asset prices, assuming financial markets are efficient. He wrote: “In short, new buyers are paying for the TBTF insurance via higher equity and bond prices. They do not receive a windfall from the TBTF status assigned to bank A.”

What If the Bank Is Allowed to Fail?

Waller also addressed what would happen if the bank was still allowed to fail after the TBTF designation was given. He wrote that initial bond and stock holders who sold after the announcement would not care, as they already received the insurance premium and would not be affected by the failure.

The current holders, however, would have paid a premium for the insurance, only to lose their investments anyway. Waller wrote: “Hence, it is not surprising that they would be upset by the government’s action. Who wouldn’t be upset after paying for insurance that didn’t pay off when it should have?”

Conclusion

Waller wrote: “To summarize, the value of being designated TBTF is capitalized into the price of a firm’s equities and its bonds. TBTF provides a windfall capital gain to shareholders and creditors at the time of the designation. But after that, new buyers of equities and debt are paying for that status. Consequently, determining who gets ‘bailed out’ when an institution is TBTF is a more complicated task than it appears.”

Notes and References

1 Feldman, Ron; and Stern, Gary. Too Big to Fail: The Hazards of Bank Bailouts. Washington, D.C.: Brookings Institution Press, 2004.